private sector opinion crashes, bailouts, regulations

A Global Corporate

Governance Forum

Publication

Private Sector Opinion

Issue 11 Foreword

With the recent stock market frauds in markets around the world such as the

Madoff case in the U.S. and the recent Satyam fraud in India, no nation can hold

its head high and claim to have good corporate governance. The reality is that

the problems of fraud, faulty audits, misleading accounts, lack of transparency,

conflicts of interest, criminal destruction of records and a long list of other cor-

porate governance violations, are not limited to emerging markets but are very

much in evidence in developed markets as well. Given recent events then, the

importance of sound corporate governance is becoming increasingly apparent.

International organizations like the OECD, the World Bank and the International

Corporate Governance Network (ICGN), along with major fund managers, are

formulating sets of codes and principles that can be applied globally. It is also

clear, however, that governments have generally done a poor job of policing the

complex world of finance and that the greater part of the task will be left to self-

policing on the part of the participants.

There is no doubt about it: sound corporate governance pays. Several studies

undertaken by various organizations have shown that: there is a direct relation-

ship between good corporate governance and investment returns. The oversight

that comes from transparency and accountability creates a structure where the

managers are discouraged from mismanaging the company, be it though a lack

of diligence or care, improper decision-making, or even intentioned unconscio-

nable behavior.

Thus, good corporate governance results in better management and more pru-

dent allocation of the company’s resources resulting in better earnings. Hence,

there could be a strong fundamental bond between good corporate gover-

nance and strong corporate performance. Needless to say, for these reasons,

good corporate governance can also lead to increases in the demand for, and

price of, company shares.

One study that appears to support this was made in 1994 by the pension con-

sultant Wilshire Associates. This study was undertaken for the California pension

Crashes, Bailouts, regulations

47663

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Private Sector Opinion — Issue 11

organization, CALPERS, which is well known for its active corporate governance

policies in the U.S. The Wilshire Associates study focused on the effects of the pension

fund’s investments in 62 companies that had, in the five years prior to the making of

the investments, lagged the S&P 500 index by an average of 85%. Five years after

the pension fund had invested in these companies and influenced their manage-

ment with their shareholder activism for good corporate governance, the share price

of those same companies outperformed the S&P 500 index by an average of 33%.

CALPERS have since estimated that the improvement in those 62 companies led to

about US$150 million in added returns.

This causal relationship between good governance and strong corporate perfor-

mance works to increase the attractiveness of investing in a company as illustrated

by rising share prices. In fact, when a company’s management is known to be better

than its peers in its accountability to minority shareholders and in its competence (to

deliver good earnings and returns for shareholders), a premium for that company’s

stock often develops.

Good corporate governance not only constitutes a moral imperative for shareholders

to be treated fairly but it simply makes good economic and financial sense.

Mark Mobius President of Templeton Emerging Markets Fund, Inc. Member of the Forum’s Private Sector Advisory Group

3

Crashes, Bailouts, regulations1

By Pratip Kar, Dean, Tata Management Training CentreThis article originally appeared in the in the Business Standard publication India 2009

This article is written at a time when global financial markets are passing through ‘interesting times’—as the Chinese saying goes—which led Paul Volcker to comment that‘…the bright new financial system—for all its talented participants, for all its rich rewards—has failed the test of the market place’. Financial institutions in the United States and Europe have either filed for bank-ruptcy, or made cosmetic changes in their business form to remain in financial services, or are choosing to be taken over by stronger institutions. In the US, the victims have been the financial institutions considered ‘too big to fail’—Washington Mutual (the largest US savings and loans association), Wachovia (the sixth largest US bank), Lehman Brothers (founded in 1850; its history is said to have paralleled the growth of the US), AIG (set up in 1919 and went public in 1969), Merrill Lynch (founded in 1914), Goldman Sachs (founded in 1869), Morgan Stanley (founded in 1935), Bear Stearns (founded in 1923) and Ginnie Mae and Freddie Mac of a more recent vintage. In the United Kingdom, after Northern Rock and the acquisition of HBOS by Lloyds TSB, there was the bust and rescue of B&B and the Royal Bank of Scotland; in Belgium, Fortis had to rescued; in Germany, HRE, a major financial institution was also near-bust and in need of a government rescue. Japan’s benchmark indices had the worst fall in two decades.

The global financial crisis is becoming more severe by the day, sucking coun-

tries into deep global recession. While the equity markets have crashed, bullion

prices are rising to record highs (to gain on safe-haven interest) and the price

of crude on the NYMEX has been falling after months of upward gyration. As stock

market misdemeanours were not responsible for holding the financial system hostage,

there is little that the securities market regulator can do to alleviate the situation.

Governments and central banks have to play the principal role in pulling the system

back on the rails. The US Federal Reserve, European Central Bank and several other

central banks lowered interest rates in a coordinated effort to ease the economic

effects of this global crisis. Governments have been providing rehabilitation packages

and injecting equity. Markets which have proffered extreme forms of capitalism and

private enterprise are being compelled to nationalise financial institutions. But neither

the short sales ban nor the expensive rehabilitation packages have so far been able

to arrest the drop in stock prices, though arresting the fall was not the avowed objec-

tive of these measures. Fear and uncertainty took a firm grip over the markets all over

the world. When the short sales restrictions were removed and the unwinding of the

credit derivative swaps of Lehman Brothers was just beginning to happen, everyone

wanted to stay in cash and was hence selling out. The Dow fell over 10 per cent from

its previous close on 9 October 2008, triggering the market-wide circuit filter. The US

stock market was halted after several years. The ability of the US Congress and other

national governments to support the stability and credibility of the financial system,

1 This article was closed on October 16, 2008

4


protect ordinary savers, depositors, businesses and borrowers and safeguard the

interest of tax payers, and restore the confidence in the financial system remains to

be seen. Since the damage has been severe, we should not get carried away or be

misled by the leavening of stock markets as an authentic signal of recovery, though

many would have us believe so.

In India, foreign institutional investors (FIIs) withdrew $11 billion till October this year, of

which $2 billion was in September and $3 billion in the first half of October alone (till 16

October). The BSE’s Sensex and NSE’s Nifty as well as the broader indices have been

on a decline. In an unprecedented move, the Reserve Bank of India (RBI) lowered the

CRR limit by 150 basis points to tide over the liquidity crisis. In September, the Index of

Industrial Production was 1.1 per cent, the lowest thus far, exacerbating selling pressure

on the securities market on stock exchanges and heightening fears of domestic reces-

sion. In a policy reversal, restrictions on Participatory Notes for the FIIs were relaxed by

the Securities and Exchange Board of India (Sebi). The underlying expectation was that

this move would prevent the flight of FII investment from Indian stock exchanges, thus

maintaining India’s attractiveness as an investment destination at a time when institu-

tional investors were pulling out of all global equity markets. The validity of this flawed

assumption has been tested by the market. The restrictions on Participatory Notes were

put in place last year to help check the surge in FII investments into India as they were

making foreign exchange management difficult for the RBI, as also on account of the

apprehension about the sources of funds and concerns about the KYC ("know your cli-

ent") norms. Both these considerations remain valid even now, raising questions about

the imposition of these restrictions in the first instance. We have to wait to evaluate the

impact of these policy reversals.

To write an article on the subject of the securities market and regulatory issues in

India in the midst of the ongoing turmoil is a challenge by itself, but to choose a title

for the article was a greater challenge. The article could be titled ‘The Future of the

Securities Market in India’. But that would be Delphic in nature, especially at this point

of time. Financial globalisation, technology and complex financial products have

strengthened the coupling between international financial markets and, by doing so,

heightened the contagion risks and increased the frequency and intensity of global

market collapses. We cannot say with conviction now that any market, unless it is

exclusive to the Andaman and Nicobar Islands or for the deeper Congo Basin, is free

of contagion risks. Predicting the future is generally a difficult task; under current con-

ditions it has got even more difficult in the case of financial markets. Nouriel Roubini

of Stern Business School was the one person who was able to read the future without

the crystal ball. On 7 September 2006, when Roubini addressed the economists of the

International Monetary Fund, he painted a lugubrious picture of an impending finan-

cial crisis engulfing the US which, he said, would ultimately lead the country to a deep

recession. The audience was naturally sceptical, even dismissive, and not without rea-

5

CRASHES, BAILOUTS, REGULATIONS

son. Economists like validation of truth through numbers and mathematical models.

Roubini had offered none.

Though weak due to rising oil prices and a softening housing market, the US economy

was still growing and unemployment and inflation remained low. At the end of the

Roubini’s talk, one economist was reported to have dismissed his hunches as those of a

career naysayer. Recounting the incident, a New York Times columnist (Stephen Mihm,

15 August 2008) wrote: ‘[When] Roubini stepped down from the lectern after his talk, the

moderator of the event quipped, “I think perhaps we will need a stiff drink after that.”…

Roubini was known to be a perpetual pessimist, what economists call a “permabear”.’

Neither could the title of the article be ‘The Second (or third, fourth, fifth) Generation of

Reforms in the Securities Market in India’, though the cognoscenti in India is in habit of

classifying economic reforms by generations. Economic reforms, of which the financial

reforms are an integral part, are usually continuous and carefully sequenced—one

reform converging into the next. It is quite unclear how a ‘generation’ of economic

reforms are identified and distinguished from the preceding ones and what is the

appropriate length of time between two generations of economic reforms.

One could, then, have titled the paper ‘Securities Market: The Way Forward’ a vari-

ant of the first title. A paper so titled could have begun with a critique of the present

regulatory architecture for financial markets in India and the arcane ways of Indian

financial regulators, proceeding then to enumerate the complete ‘things to do’ list

(with full convertibility at the head of the list). But such a title would have been apt for

a consultant’s report, and would have seemed to be an advisory of sorts for the securi-

ties market regulator. Having worked in the regulatory body for nearly two decades,

one realises that the temptation to pontificate without the responsibility of execution

and accountability can often be irresistible.

What then is this paper all about? it is about the issues and concerns relating to the

securities market and market regulations in india in the perspective of the current

world scenario. rather than a menu of advice and suggestions, it is in the nature of

peregrinations of thought through the capital market in india.

Owing to globalisation and advances in technology, global financial crises are increas-

ing in their intensity and frequency: on securities markets on an average, they have

been occurring at a frequency of 4.5 years in recent times. This is alarming by itself.

But what is more alarming, is that the present one should have happened post-Enron

and the Asian financial crisis. After these two cataclysmic events, central banks and

securities market regulators set up a powerful international forum for regulatory coordi-

nation—the Financial Stability Forum (something like our own High-Level Committee for

Capital and Financial Markets)—and adopted a series of measures to avoid contagion

6


risks, as if such risks can be avoided in a globally integrated market place. Obviously,

these measures have not yielded much result. And now, with the talk of overhauling

the regulatory system, there is the possibility of the pendulum swinging in the other

direction. Furthermore, despite the enormous increase of disclosures and stringent risk

management systems in the us post the sarbanes oxley act (soX), the inability of the

system to read the early signs of the impending disaster and willingness to take cor-

rective action raised the question of what more does one need to do. Finally, the sheer

size of the financial mess at a ‘fair value’ of over a trillion dollars (aggregate of all the

rescue packages till now) seriously questions the ability, competency and robustness of

the present regulatory architecture for the financial markets faced as it is with unbridled

greed and failure to impose punitive action for symmetrical losses.

Financial crises usually provide a good opportunity for introspection on the functioning

of financial markets and the regulatory architecture. These times invariably expose the

shortcomings and vulnerabilities of the system. The present crisis, with its widespread

ramifications on global markets and economies, is one such great opportunity to reas-

sess the existing views on financial markets, the role of financial institutions, market

structure, financial products and, above all, on the regulatory architecture. It would be

worthwhile to debate some possibilities relevant in the Indian context. But while review-

ing and reassessing the present, extremes of regulatory action need to be avoided.

First, global financial markets have become far too complex, fast moving and inte-

grated for the global regulatory architecture (which has so far helped supervision and

regulation) to work any longer. This will be true for India as well, even though complex

derivative products are not yet available in our market. Financial crises have never

put an end to financial innovation or brinksmanship and it remains likely that we will

see new and complex products emerge in our market too, out of necessity (though

this may not happen immediately). The regulatory architecture in India needs to be

geared to deal with such outcomes.

Second, the present financial crisis has made irrelevant the debate between libertari-

anism and authoritarianism in the area of market regulation. The fountainhead of the

present global financial crisis—the one-to-one transactions in the derivatives markets

for mortgage-backed securities and structured products—were all private. These were

only lightly and indirectly regulated, perhaps following the philosophy of Friedrich von

Hayek.2 Besides, the transactions were opaque in terms of legal obligations and risks.

There was both an incentive to hide overall credit risk from the markets and an ability

to take such risks without proper due diligence. AIG, which avoided collapse with a

$85 billion rescue package, is an example of this approach. Whether lighter regula-

2 Friedrich von Hayek was a proponent of classical liberalism and free-market capitalism. He is considered to be one of the most important economists and political philosophers of the twentieth century.

7


tion, with greater reliance on self regulation and private counterparty surveillance, is a

preferred regulatory model, or whether a single regulator is better than a multiple reg-

ulator model, or whether a principle-based regulatory regime is more effective than a

rule-based one—all these are questions which have befuddled all shades of opinions.

Financial markets in Europe, the US and Japan, all now in trouble, have experimented

with all these models and there is no evidence to suggest that one country has been

better off than the other.

There is a lesson in this for our home-grown, laissez faire, freelance advisors. It would

serve little purpose for us to adopt a model or architecture or to change an existing

one merely because it works elsewhere. The choice of a regulatory model and the

architecture should be a function of a country’s own ethos and legal system. What is

important is that the system adopted should have the agility to read the early warn-

ing signals of a brewing crisis and take corrective measures, rather than be lulled into

complacency by rising asset prices (as has generally been the case).

Third, rise in asset prices makes people happy as wealth is created. Nobody wants

to know the reason for the price rise or if the price rise securities market is warranted

or the returns abnormal. Rise in asset prices attracts new investors to the market,

creates new demand and feeds into the price rise, making the owners of the assets

happier. This is almost an eternal verity. We have seen this during the present crisis;

we have seen this in India. The rise in equity prices (with the Sensex soaring beyond

20,000) as well as property prices led to the extraordinary popular delusion that asset

prices can only move in one direction—upwards. Many of us facetiously regarded

the rise in indices as a vindication of economic policies; we forgot that there are

many indicators of economic growth and the stock market index is just one of

them. We forgot that in an imperfect market—and the Indian stock market remains

imperfect in many ways—the indicators would necessarily be imperfect. There is

no discounting the fact that India’s economic performance has been stellar by all

major parameters of macroeconomic performance, leading to the ‘India story’. But

we forgot to ask if the story was being blown out of proportion. On the one hand, we

reassured ourselves that contagion risks would not affect our system and hoped that

the FIIs would show a preference for our market, but we were happy when our stock

market indices rose phenomenally on days when the global markets also rose. We

did not enquire if the rise was on account of significant FII investments on those days

compared to other days. It is important that authorities ask the right questions at the

right time. In the case of Enron, nobody, whether inside or outside the company,

asked why. Similarly, with Bear Stearns and other investment banks; nobody critically

examined their rise (when money was being made by individuals and the firms, and

when phenomenal bonuses were earned), till they failed. It is important to question

any abnormal return, any abnormal profit, especially when a ‘specious association

between money and intelligence’ is witnessed.

8


Fourth, there is a wild animism inherent in financial markets, a kind of natural impulse

which is displayed through speculation and through market volatility. When this urge

becomes widespread, speculative excesses occur. Speculation then creates its own

reality. Though libertarianism is the best and most desirable concept for market regula-

tion, it is, for the reasons just cited, only an ideal one, more so when the market is under

a speculative spell. This leads to the need to strike a balance; while leaving everything

to market discipline does not work (as Mr. Greenspan discovered to his dismay), a

completely fettered future would also prove to be futile as it would stifle innovation.

Striking this balance is the most difficult part of financial regulation. For example, the

much-maligned instrument of credit default swaps (CDS) has been in place for quite

some time. In 2004, the estimated notional value was $6 billion according to the Bank

for International Settlements. Between 1998 and 2001, these instruments were used

to spread risk of $1 trillion in loans to the rapidly-expanding telecom network. Even

though a large proportion of these ventures defaulted during the tech bust, not a

single major financial institution ran into trouble. The losses were borne by highly capi-

talised institutions—insurers, pension funds and the like—who were the major suppliers

of credit default protection. By 2006, the notional value rapidly rose to $20 trillion. Was

the financial instrument the problem or its rapid growth?

Fifth, financial crises have, by and large, exhibited a repetitive pattern, demonstrating

the inability, or unwillingness, of financial market participants to learn. Charles Mackay,

in his book Extraordinary Popular Delusions and the Madness of the Crowds, says that

while episodes of panic and disasters have their own distinctive features, they exhibit

a common feature—that they are all preceded by a period of apparent prosperity

when it is possible to rapidly acquire fortunes ‘otherwise than by the road of plodding’.

In their study of 18 financial crises in the US, economists Carmen Reinhart and Kenneth

Rogoff of Harvard Business School found that there were ‘stunning qualitative and

quantitative parallels across a number of standard financial crisis indicators’. Ahead

of each big financial shock, house prices rose rapidly, as did equity prices; current

account deficits ballooned; and capital inflows accelerated. Isn’t there an uncanny

resemblance with the situation at home? Wasn’t there a fairly long period of abnormal

increase in property prices and stock prices? Little has been done to enquire into the

behaviour of the property and stock markets, perhaps fearing that such actions could

spook the rise in asset prices.

Sixth, financial crises do not play favourites, and no institutions are spared. But it begins

with the actions of large institutions, which become too big to fail. There cannot be

anything wrong in growing aggressively but the strategy adopted is very critical as

this is often where the dangers lie. Financial services firms which are known to grow

aggressively need to be carefully watched. Timely regulatory action always helps,

whether in global markets or in India, even if such action may seem to spoil the party.

More often than not, the pursuit of growth leads institutions to adopt sharp practices.

9


For example, Bear Stearns was known for its notoriously freewheeling—some would

say maverick—culture. Bear had pledged to fork out more than $3 billion the previous

summer to bail out one of its two hedge funds that had bet heavily on sub-prime loans.

This itself should have sounded loud alarm bells.

The organisational culture, dependent as it is on the tone on the top, is crucial. For

example, at ’Phi Kappa Wall Street, the image of Bear Stearns was that of tough-guy

loner, scrawny, wearing its beat-up leather jacket and nursing a cigar, and who dis-

dained secret handshakes and towel snapping in favour of an extended middle finger

toward pretty much everyone.’ It was said that in Bear Stearns, unlike in Goldman

and Morgan, your pedigree mattered little. What mattered was whether you could

make money on the trading floor, and sufficiently. Its long-time chairman Alan ‘Ace’

Greenberg even coined a name for his motley hires: PSDs, for 'poor, smart, and a deep

desire to get rich’. Time and again, such institutions have won accolades and plaudits

from the market and authorities to the total exclusion of adverse opinion or criticism.

But later, it was discovered that what was considered to be ‘unusual acuity of returns

[was] only a fortuitous and unfortunate association of assets’. This is true for all institu-

tions and individuals who are now under a cloud in the global market.

In India too, there are a number of financial institutions who have grown aggres-

sively and their businesses now straddle various financial services as well as the real

estate sector. They employed phalanxes of very smart people, people trained under

Mametesque pressure-cooker conditions to create new products, and to sell them

with utter disregard for ethics. These institutions need to be cautioned. In financial ser-

vices, it is the attitude and approach of the foot soldiers and the frontline staff towards

ethics which would signal the tone at the top. It would be useful to watch out for such

early warning signals.

Seventh, the genesis of market misconduct and financial crises on a big scale usu-

ally lie in areas which are either unregulated or lightly regulated and which operate

by leveraging to the hilt. Unregulated banker’s receipts used in the latter part of the

1980s by Harshad Mehta are an example. Credit default swaps, mortgage-backed

securities and other collateralised debt obligations were lightly and indirectly regu-

lated. Enron operated in the borderland while complying with the disclosure stan-

dards and governance norms on paper. It is important to identify such institutions

and instruments and appropriately ring a fence around them. In India, non-banking

finance companies (NBFCs), private equity players and private sector banks are

three such institutions. While all these institutions are crucial for our markets, we

should not become oblivious to the risks they carry. Several of these institutions have

been included in the category of Systemically Important Financial Institutions by

the RBI. But is that enough? Such institutions should usually always be kept under

careful scrutiny, which should go beyond off-site inspection and periodic reports.

10


Not only should their CEOs be interviewed periodically by the regulators, but their

annual reports and periodic financial statements should also be analysed. Financial

statements are places where one can easily detect frauds. A hands-off regulatory

approach does not work with such institutions.

Eighth, financial crises, either global or domestic, transform ‘something close to uni-

versal trust into something akin to universal suspicion’ as Galbraith remarked in his

book The Great Depression. Under these conditions, it becomes difficult for regulators

and legislators to make the wisest decisions or take the best measures. Regulations

originating in a crisis tend to be extreme and such measures often lead to expensive

regulation. The Sarbanes Oxley Act is one such example. The question is: if the financial

crisis could not be detected despite the expensive disclosures and risk management

requirements of this act and NYSE rules, are such rules serving the purpose? The recent

banning of short sales in the US, Europe and Australia is another example. Banning

of short sales is an extreme securities market measure which has not worked in any

market. It does little to arrest the decline in prices; on the contrary, when the ban is

removed, a flood of pent up sales push the market down further. This was tried in India

too on a couple of occasions, and with little effect. We ought to refrain from taking

any quick-fix regulatory measure—either as a precautionary or prophylactic step or

for lifting the market sentiment. Market sentiments cannot be talked up or down and

when fear grips the market it would be futile to try and impact the prices by comfort-

ing statements. For example, the famous Greenspan speak of ‘irrational exuberance’

had affected markets only for half a day. Markets are known to respond to the casual

market-reviving measures only casually, as they did to the recent Participatory Note

related policy changes. What works are measures that ensure that liquidity never dries

up. That is the responsibility of the central banker.

Ninth, derivatives are useful financial instruments. Just as financial markets cannot

function without speculation, derivatives too are necessary for market efficiency.

However, it is important that authorities understand the nature of the beast. Derivatives

feed on leverage, and leverage feeds on greed. A combination of these leads to

complexities in derivatives. When Bear Stearns ideated credit derivative swaps it may

not have imagined its destructive potential. It saw the market in credit derivatives

swaps as a place to make money. The instrument became so complex that, at one

point, few understood who was taking the credit risk and this lead to a mispricing of

risk. But complex derivatives helped make more money and puff up the bottom line,

and earn more bonuses. No one could object. No one did. As yet in India we do not

have complex derivatives or complex structured products based on securitisation.

Nor has the securitisation market picked up. But there are a variety of derivative instru-

ments in the stock market (index-based and stock-based futures and options) and

exchange-traded currency futures have been introduced in the currency market. But

even these simple derivatives could cause severe risk-management problems unless

11


one is careful. Though currency futures have the potential to adversely impact the

exchange rate, there is already a demand from market participants to dilute some of

the safeguards which, they contend, are making the market inefficient.

In equity derivatives, for example, one could question why stock futures have gained

popularity (even with FIIs) in our market in comparison to anywhere else in the world. It

could be that stock futures closely resemble the erstwhile carry-forward system which

the market is familiar with; and it is possible that brokers and clients have found a way

of using stock futures in a manner similar to the carry-forward system. This large market

for stock futures could also be the reason why the short selling has not picked up in

India. It may be useful to understand why the number of stocks eligible for stock futures

far exceeds the number of securities eligible for carry forward and how it would benefit

the stock exchanges to increase the list. It would be interesting to enquire why the vol-

umes in stock futures are often multiples of the cash market, or if stock futures and index

futures contribute to the phenomenal increases in market capitalisation, or market vol-

atility, or why the open interests remain very high in stock futures, even when the stock

market falls. It would also be worthwhile to find out if management and promoters of

companies are using stock futures in the same way as they used the carry-forward sys-

tem to help increase the valuation of their stocks and influencing the index. But no one

has tried to find out the hows and whys. At least the stock exchanges did not.

Tenth, the growth in the size, role and complexity of the stock market makes its regula-

tion more difficult than ever before. There needs to be a sharing of regulatory burden

between the stock exchanges and the central regulator in India. The stock exchang-

es—the BSE (Bombay Stock Exchange) and the NSE (National Stock Exchange)—have

two functions. One, is to provide a trading platform and, two, to perform the regulatory

function of disciplining its members. Stock exchanges have done an excellent job with

the former but have not particularly distinguished themselves in the latter and it may

now be time to segregate the two functions. The regulatory function could be spun off

into a separate body common to both stock exchanges, which would report to the

central regulator and oversee the monitoring and supervision of the stock exchanges

and the members. It will allow the regulator to devote greater time and resources to

policy and overall market supervision.

Eleventh, related to the regulatory model just outlined is the adoption of the concept

of the self-regulatory organisation (SRO). If this is to be adopted, it must be done with

reference to its relevance to India. Given the way our market has grown, it may not

be easy for all our intermediaries to form SROs keeping in mind that taking action

against fellow members is not an easy task, at least in India. Under the circumstances

it might be easier to work with the association of NSE members—ANMI—which has

now converted itself into a national body. If ANMI is nudged into being an effective

and efficient SRO over the next one year, it might serve a very important function for

the securities market.

12


12

Twelfth, competition is important among stock exchanges. But to compete effi-

ciently, they must have products which differ in features and benefits or, even if these

parameters are the same, they must be distinguishable in service quality. Without

any product differentiation, the market gets segmented, leading to efficiency losses

when the same product is traded on more than one exchange. The BSE and NSE

are now trading identical products in equity; even arbitrage gains between the two

are insignificant. Unless one is trading in very large volumes, arbitrage gains remain

small. Other 19 stock exchanges have been de-mutualised and are in existence

without any business. In the past, when account period settlement was prevalent,

the dates of the settlement varied from exchange to exchange. It was this varia-

tion in settlement cycles, complemented by the availability of carry-forward trad-

ing, which made product differentiation possible even if the same security was

traded in multiple stock exchanges. The issues that need to be debated are: one,

is there any purpose in having two stock exchanges that trade the same product

with indistinguishable features and benefits? Two, is it politically incorrect to merge

the 125-year-old BSE with the NSE to gain advantages of size, liquidity and depth?

Three, would it be a loss, financial or national, if the non-functioning exchanges were

closed down and the companies wound up under the Companies Act? Four, with

one stock exchange, would the overarching regulation and governance structures

need to be strengthened?

Thirteenth, India has a fledgling mutual funds sector wherein funds have chosen the

easy growth path by approaching the corporate sector for investments rather than

tapping individual investors by developing a large network across the country. The

Association of Mutual Funds of India has done precious little in diversifying the sec-

tor or contributing to its growth. If efforts were made to encourage individual inves-

tors (across the urban and rural landscape) and wean them away from competing

investment opportunities, a strong countervailing institutional mechanism may have

been available. Countervailing forces are essential in stock markets and the greater

the diversity of investor classes in a market, the greater the possibility of competition

(as diverse investor classes will have different horizons) and the greater the market

efficiency.

Fourteenth, the present crisis did not originate in India. To a large extent, we are fac-

ing the consequences of events beyond our shores. It is a great tribute to the cau-

tious and judicious policies of the RBI and the government that we do not have the

kind of runaway laissez faire economics which has allowed global financial markets

to indulge in products which were exciting and exotic at the time of launch but

carried in them the seeds of destruction. The present global financial crisis is not an

account of market misconduct but the result of deliberate leveraging, mispricing of

risk and asset bubbles. Although several confidence-building measures have been

13


taken, we may not have come to the end of the tunnel. Fears of a US as well as

global recession will not die down so soon. It is important that this is understood and

we should not get carried away merely by the performance of the stock market or

the housing asset bubble and parade them as indicators of prosperity. It is equally

important that we take a deep dive to clean up our own house by taking deeper

systemic measures.

This article has deliberately not touched upon new products that need to be intro-

duced in our stock market. The job of identifying and developing such products should

be left to stock exchanges and market participants, rather than the regulator. The

latter should be tasked with managing the products through appropriate regulations.

This paper does not touch upon the process simplification measures to improve mar-

ket efficiency as the central regulator is doing a commendable job. It also does not

talk about the debt market because there are volumes of reports on the subject and

if the latest securities market comprehensive report is implemented, the debt market

in India would have a new face. All this apart, the report on how to make Mumbai

an international financial centre seems to have included every conceivable financial

instrument and policy change that needs to be Introduced in India to magically trans-

form a city with crumbling infrastructure into an international financial centre.

Finally, my pet peeve. The stock market is ruled by powerful emotions and desires—

greed, fear, hope, uncertainty and hubris—which control the behaviour of stock

markets and investors. Various theories and economic models rationalise these

emotions and desires. ‘Fear is an automatic response in all of us to threats to our

deepest inbred propensities. It is also the basis of many of our economic responses.

It is difficult for investors to imagine when markets veer from rational to irrational,

from euphoria to fear and back again’ (Alan Greenspan, The Age of Turbulence).

Behind the CDSs, CDOs and MBSs and the widely-used ‘originate and distribute’

model of securitisation lies the real originator of the sub-prime problem—inordinate

greed. This is reflected in the flawed system of executive compensation by way of

bonuses tied to short-term profits for the bankers, heralded as the proud pennants of

free market and capitalism. all of these concerns fall squarely in the domain of ethics

and corporate governance, the role and responsibility of the Boards, especially those

of financial institutions.

The sub-prime crisis originated in highly professional financial enterprises, served by

highly knowledgeable and competent boards, complemented by a talent pool

drawn from the best business schools, extensive disclosure requirement, and an elabo-

rate risk management system. Compare this to Mohammed Yunus’ Grameen Bank

which was set up in 1976 to lend microcredit to the impoverished without requiring

collateral: it has a borrower base of over 8 million and an outstanding loan portfolio

of $313 billion (as of October 2007) and has a loan recovery rate of 98 per cent. We

14


may analyse and attribute the success to the business model, we may determine that

that model would not be relevant and appropriate in a world where it is customary

to wear pinstripe dark Versace with a pink shirt and tie but, in reality, the Grameen

Bank is in the financial service business and is not a charitable institution. The only dif-

ference is that there is absence of greed, high standards of governance and high

degree of accountability. Markets and regulators need to look at the entire subject

of ethical business conduct and governance standards afresh, especially in financial

services firms. In India, corporate governance and ethical business conduct are areas

which need careful attention, by the regulators, the stock exchanges and the gov-

ernment. This would mean that there is a need to go beyond box-ticking compliance

and make it a part of business strategy. This is yet to happen in a big way in India. For

example, banks, even the listed entities, have their own corporate governance and

ownerships standards which are different from what has been prescribed in Clause

49. Public sector companies which are listed on the exchange have to necessarily

follow government policies, and have to address societal needs, even if such needs

are at variance with shareholder interests. Private sector companies are governed by

the legal framework of the Companies Act and the listing agreement for corporate

governance; more often than not these two provisions are contradictory rather than

complementary. This does not make sense. It is important that regulators work towards

a uniform and harmonious governance standard which addresses issues of gover-

nance comprehensively and is applicable to all listed companies, irrespective of the

regulatory jurisdiction.

This crisis has shown that organisations, especially in financial services sector, need to

be founded on an ethical value system if they are to be successful in the long run. no

regulatory ring-fencing, no funds injection by national governments, no confidence-

building will work unless governments, central banks, regulators and financial ser-

vices companies realise that the success of laissez faire economics is predicated on

a system of values and ethics.

15


About the Author

Mr. Pratip Kar is currently the Dean of Finance and Corporate Governance at the Tata

Management Training Centre (TMTC) in Pune. He joined TMTC in September 2006. He

designs and delivers programmes in finance, financial regulations, ethics and corpo-

rate governance at TMTC.

Mr Kar holds a MBA degree from INSEAD, a Certificate in Banking from the Indian Institute

of Bankers, and a Post graduate in solid state physics with a year’s post- MSc experience

in nuclear physics from the Calcutta University. He is proficient in French language.

He is a Member Board of Governors, National Institute of Securities Market, set up

by the Securities and Exchange Board of India, Member CII National Council on

Corporate Governance and a Member of the India Advisory Council of the Global

Corporate Governance Forum—an IFC multi donor trust fund facility.

He has been in the financial sector in India for nearly three decades, of which ten

years (1977–88) was in development banking and project finance with the Industrial

Finance Corporation of India and Industrial Development Bank of India and twenty

years with the capital market.

He joined the Securities and Exchange Board of India (SEBI) when it was set up in 1988,

and was with it till September 2006. He became the Executive Director of SEBI in 1992.

During his 18 years tenure in SEBI, he was closely involved with the economic reforms

in the country and with the reform of the Indian securities market. He helped frame

the regulatory framework and policy for the securities market, and implement the

regulations relating to primary issues, disclosure norms, accounting standards, corpo-

rate governance, takeovers and substantial acquisition of shares, foreign institutional

investment, mutual funds, automation and modernisaton of the stock exchanges,

regulations of the stock exchanges, demutualisation of stock exchanges, regulation

of the equity, bond and derivative markets, risk management, dematerialisation of

securities, clearing and settlement systems, surveillance and investigations and policy

research. He also drafted the SEBI reports on Corporate Governance and framed the

Clause 49 of the listing agreement which lays down the requirements of corporate

governance in India.

He also has a rich experience in international securities market regulations and has

been a regular participant at the meetings of the International Organisation of

Securities Commissions (IOSCO) as well as the Organisation of Economic Cooperation

and Development (OECD) and the World Bank in the areas of securities market and

corporate governance. He has been a member of several high powered committees

and working groups set up by the Government of India, the Reserve Bank of India,

16


SEBI, the OECD and the World Bank. He also has several publications to his credit in

the field of capital markets.

His areas of specialization are: corporate governance, domestic and international

regulatory framework for capital markets, compliance, risk management and internal

controls, mutual funds, derivatives, foreign portfolio investment, mergers and acquisi-

tions, raising of capital in domestic and international markets.

18


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